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Why Investors Shouldn't Always Shy Away From High-Paid CEOs

Let's remember for a minute the story of former Tyco International (NYSE: TYC) CEO Dennis Kozlowski. Anyone with an MBA, or who had read a newspaper in the early 2000s, knows this story -- but I get a kick out of it every time it comes up. The ultrawealthy corporate leader squandered $6,000 on a shower curtain, $2,900 on coat hangers, and $15,000 on a dog-shaped umbrella stand (well, who doesn't need one of those?).

Kozlowski's outrageous spending, more than $110 million in white-collar theft, and subsequent imprisonment are quite well known. What is less well known is that, despite his nine-figure theft, he earned over $300 million in the four-year period 1998-2001. Why in the world would a company intentionally pay a CEO that much money? Let's look at executive compensation and what it means to investors.

What is executive compensation?Executive compensation is simply the value of everything that an executive (we'll focus on CEOs) gets for being the CEO. In general, CEOs receive multiple forms of compensation, including a base salary, an incentive cash-based bonus, short-term stock grants and options, long-term stock grants and options, and a slew of others (pension, company car, etc.).

How is executive compensation set?Every company sets a unique executive compensation plan for its leader. Generally, a few members of the company's board of directors will form a compensation committee and they will set all of the baselines and benchmarks related to the CEO's total compensation package.

To answer the question that just popped into your head: Yes, CEOs can have significant influence on the decisions made by their compensation committees (especially when the CEO is also the chairman of the board, as Kozlowski was), and CEO pay packages are not always unbiased. But we'll leave discussing CEO influence on the board for another time.

The common forms of CEO payBase salary: a check in the mail every month, just like the ones the janitors and parking attendants get.

Cash bonus: an additional cash payment that CEOs get, assuming they meet some short-term goal. Unfortunately for some investors, there is evidence to suggest that CEOs often get this cash bonus whether they meet their short-term goals or not.

Stock grants: a bunch of stocks that the CEO gets for meeting certain short- and long-term goals. These (along with options) often make up the majority of CEO total compensation, especially for larger companies. Investors take heart: Unlike cash bonuses, companies are much better about not paying these stock grants if the firm doesn't perform well under the CEO.

Stock options: the right to buy shares of the company's stock, given to the CEO, if certain goals are met. Typically there will be a vesting period of a few years where the CEO can't touch them.

What do these forms of payment mean to investors?Simply put, the more money a company pays its CEO, the less money is left over for its investors. Below we can look at each type of payment and decide what it means for us investors.

Basically, base salaries and cash bonuses are going to be paid to CEOs regardless of how they do (assuming they don't pull a Kozlowski and get fired). As investors, we don't like to see too high of a cash payment, so that the company can hang on to that wealth if the CEO doesn't earn it.

Stock grants are the best form of payment, in my opinion. If the CEO holds a large portion of their personal wealth in the company's stock, they are very likely to do everything they can to maximize the value of that stock. This works out well for you, the investor, who surely wants the same. Even better is when the stock grants are blocked for a period of a few years: The CEO must do a good job for a long time before they can cash out. These are called restricted stock grants, and they benefit you, the long-term investor.

Stock options are good in the same way that stock grants are good. But because of the way people make money on stock options -- capitalizing on the difference between the set exercise price of the option and the market price of the stock -- option holders may be incentivized to alter their behavior to maximize the value of their options, in a way that could hurt the value of common stock; for example, reducing dividends would help an option holder and potentially hurt a common stockholder.

How to research executive compensationNow that you know the different kinds of executive compensation out there, and what they may mean for you, it's time to incorporate it into your regular research. If you're researching big companies, it's likely that the information is already nicely compiled on a credible investing website. But if you have to dig around for it yourself, thankfully it's pretty easy!

Pull up most any annual report and what's included is a compensation report, remuneration report, or something with a similar title. If it isn't in the annual report, the annual report will point you to a separate proxy statement to read. It's usually a few pages long and can be a little dry. But by the time you get through it, you'll have a good feeling of how a CEO is compensated, and you can decide if their interests are forced to align with yours.

Kozlowski's compensation packageSo, what was it about Kozlowski's compensation package that allowed him to decide it was in his own best interest to steal from the company? After all, the goal of an incentive package is to force the interests of the CEO to align with those of the shareholders. Below is a breakdown of Kozlowski's 1999 compensation.

Dennis Kozlowski Compensation (as reported in Tyco proxy statements)

Year

Salary

Bonus

Restricted Stock Grants

Total (excluding options)

Options

Total (including options)

1999

$1,350,000

$3,200,000

$25,707,178

$30,257,178

$68,420,000

$98,677,178

OK, what do we see here? We see $4.5 million in salary and bonus. That's a huge number, but it isn't too big compared to the total compensation, so no red flag there. I love to see that high number in restricted stock grants. As an investor, if I know that Dennis Kozlowski has $25 million of stock in Tyco and is going to hold it for at least a few years, I'm going to be pretty confident that he's going to maximize the value of that stock -- which is exactly what I want. As for the options, $68 million is a lot, and options can sometimes be problematic, but generally the goals of option holders are very close to the goals of stockholders.

I would have liked Kozlowski's options to have been restricted for a much longer period, so that he could earn this money only if the company did well for a very long time. But overall, this isn't a terrible compensation package. The fact is that while compensation packages often do a very good job of aligning executive goals with those of shareholders, they're not a complete safeguard against greed and corruption. Kozlowski was set to earn a staggering amount of money legally and still decided to steal over $100 million of shareholder wealth.

Incorporating compensation analysis into your regular research will help see that management incentives are aligned with your own, but you also should make a qualitative assessment of the character of the individuals running the company. While you may not be able to identify future white-collar criminals just from reading a few press releases, thinking about the alignment of goals, compensation breakdowns, and character just may keep you from investing in a company headed by the next Kozlowski.

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